Taxes: Not Always a Big Deal

Jul 22, 2015

Article By: Scott Burns

Q. When my mother died in 2010 she left me an annuity. I am retired. My husband and I live on our Social Security and a small pension.

I had five years to do something with the annuity. I'm not sure if I did right or wrong, but I left the annuity intact for four of the five years. In 2014, I took $11,000 out of the annuity and paid 10 percent to the IRS before distribution.

This year I have to take out the remaining $58,000. I only have to pay federal taxes on $8,000. The rest is the original amount of the annuity.

Do I have to pay income taxes (over the amounts already paid by my mother and myself) on the $58,000 because I left it in the annuity instead of slowly taking it out?

I’ve read that it is better to give the money to a charitable organization than to the IRS. So, if I have to pay an exorbitant amount to the IRS, I would rather give it to a charitable organization. How much would I have to donate to eliminate being taxed again? ---P.R., by email

A. If this annuity isn’t part of a qualified plan investment, your only tax liability will be for the amount that has accumulated over the original $50,000 investment. Paying taxes on $8,000 isn’t likely to raise your tax bracket. Even if you were in the 25 percent tax bracket, your only tax bill would be $2,000 out of the $58,000. No one would call that exorbitant or punitive, so cash out and enjoy having $56,000.

If you really don’t want to pay any additional taxes, you can donate $8,000 to your favorite charity (or several), and the donation will offset the $8,000 of taxable income when you redeem the annuity---if you itemize deductions on your income tax return. It’s best to confirm with a trusted tax preparer.

Q. I am 76 years old and have two grandchildren, ages 7 and 5. I would like to provide something for their college education. But I don’t know the best way to go about it.

Should I be looking at 529 plans, or what? I want to make sure the money goes to their education but I probably won’t be here when that times comes. My children (and I) live in Texas and they graduated from A&M with advanced degrees. ---J.P., Austin, TX

A. You can always contribute to 529 plans. But you might also consider something with greater flexibility. You could create a separate brokerage account, in your name, with a major platform company, like Fidelity or Schwab. Then think of the money in that account as the grandchild education account.

If it is committed to equities in an ultra-low-cost exchange-traded fund, it will have more risk than a balanced account, but it will be very tax-efficient. What’s taxed will be taxed at low capital gains/dividend rates. The account can be earmarked in your will for distribution to the grandchildren.

If your death precedes their going to college, there will be a step-up in cost basis. The grandchildren will get any assets at a higher cost basis, escaping any capital gains tax. Live until they enter college and you can have the fun of writing some of those big checks.

I know this isn’t the conventional wisdom, but keeping control of the money doesn’t hurt your grandchildren. It may deliver money to them with great tax and cost efficiency.

But the big benefit is flexibility. While your children may have graduated from A&M with advanced degrees, that’s no guarantee your grandchildren will. It isn’t even certain that they will want to go to college. This reality is an enormous source of anguish in many well-educated families.

What’s truly important is providing kids with the money that opens doors. That could be education. But it can also be down payment money for a home or money to start a business.

Having access to some money is a great gift-- and it may be as productive as a college fund.

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